In Defense of Markets

Cap-and-trade has been demonized by conservatives as part of an effective strategy to stop climate legislation from moving forward in the U.S. Congress. As I wrote in my previous blog post (“Beware of Scorched-Earth Strategies in Climate Debates,” July 27, 2010), this unfortunate tarnishing of market-based instruments for environmental protection will come back to haunt conservatives and liberals alike when it becomes politically difficult to use the power of the marketplace to reduce business costs in the pursuit of a wide variety of environmental objectives.

Cap-and-trade has been vilified as a national energy tax, an elaborate Ponzi scheme, and a giveaway to corporate polluters. The fact that none of these attacks are factually correct has not seemed to reduce their political effectiveness. This is one element of the poisonous atmosphere which has come to dominate so much of national political discourse, at least in this election year.

When Senate leaders decided they could not assemble the sixty votes necessary to cut-off debate on meaningful climate legislation, they pulled nationwide, economy-wide cap-and-trade off the table, quite possibly until after a new Congress is seated in January of 2013. But when serious attention is again given to meaningful national climate policy, as it surely will be, consideration will inevitably include carbon-pricing, whether in the form of carbon taxes or cap-and-trade, because these approaches have tremendous advantages over the alternatives (“The Real Options for U.S. Climate Policy,” June 23rd, 2010).

While the justification for putting a price on carbon emissions seems straightforward to most policy analysts, some of the public and even some policy makers have questioned whether creating a market for greenhouse gas (GHG) reductions would be a cure worse than the disease itself:

Would a market-based approach to reducing greenhouse gas emissions be a corporate handout?

Can markets be trusted to reduce emissions?

Will a market-based approach, such as cap-and-trade, be too costly?

Are other approaches likely to be more effective and less complicated?

In our report, Janet Peace and I respond to all of these questions, but in today’s blog post I will highlight our response just to the first question. For the full and complete story, I urge readers to see the original report, which can be downloaded freely from the Center’s web site.

Why create a market for GHG emissions, when markets – in general – are subject to manipulation and have failed terribly?

With the U.S. economy experiencing its worst recession since the Great Depression, amidst corporate scandals, pyramid schemes, and a series of government bailouts, some members of the public as well as elected officials have come to question the ability of markets to perform their basic functions. Despite the past successes of market mechanisms to address environmental problems such as acid rain, leaded gasoline, and stratospheric ozone depletion, this growing distrust of markets has led some to question whether market-based approaches are appropriate instruments to help tackle the exceptionally challenging problem of global climate change.

The storyline goes roughly like this: establishing a “carbon market” for greenhouse gas emissions opens the door for financial intermediaries – banks and brokers – to be involved. Since we know that they cannot be trusted, and only care about making profits (and not about reducing emissions), how could any approach that involves them be part of an effective solution?

In reality, of course, our recent economic turmoil does not mean that “markets” in any general sense do not work; only that markets require appropriate oversight. Our economy fundamentally is a market-based system, but oversight – including, where appropriate, effective rules and regulations – can be essential to ensure transparency and prevent manipulation.

Studies that have evaluated the performance of these market-based approaches to environmental protection have found that they have achieved their environmental objectives and have done so at lower cost than conventional, command-and-control approaches. Estimates of cost savings range from 7 percent to 96 percent, with more than half of studies showing that market-based programs cut the cost of regulation by well over 50% compared with command-and-control options. For example, the SO2 allowance trading program resulted in 33 percent cost savings — on the order of $1 billion annually, while reducing power-sector emissions from 15.7 million tons in 1990 to 7.6 million tons million tons in 2008. The phase-down of leaded gasoline in the 1980s, which employed trading of environmental credits, was also successful in meeting its environmental targets, while yielding cost savings of about $250 million per year.

The evidence is incontrovertible – market-based approach to environmental protection can work, effectively achieving environmental targets and keeping costs to a minimum. These approaches are not deregulation, but reformed and improved regulation. And like all markets, these environmental markets need rules and oversight.

A Real and Pressing Problem

The fundamental reason why we face the threat of global climate change is that there is no price or cost for emitting greenhouse gases. In the absence of a price, the damages associated with a changing climate are not considered by companies or individuals when they make their energy choices. A cap-and-trade policy creates this price by establishing a limit on the amount of greenhouse gas emissions and allowing firms covered by the program the flexibility to trade allowances. The environmental integrity of the program is ensured by the “cap” on emissions, and the costs of the program are kept as low as possible through the creation of a market (where firms can buy and sell allowances).

Concern about financial markets and fraudulent investment scams has created an atmosphere of distrust regarding the functioning and effectiveness of markets. By extension, questions have been raised about the wisdom of creating a market with a cap-and-trade program for controlling greenhouse gases. In truth, appropriate oversight and regulation of carbon markets will be required. The problem has been the abuse of markets, not something fundamental about markets themselves.

Climate change is a real and pressing problem. Strong government actions are required, as well as enlightened political leadership at the national and international levels. Creation of a market for greenhouse gas emissions can work, but is contingent on government action to establish this policy. When the Congress decides to return to this issue ­– as it inevitably will – cap-and-trade policy specifically and carbon-pricing generally must be considered seriously and debated honestly, otherwise it will be fundamentally impossible to provide the right incentives to put the United States on a climate-friendly path of robust and sustainable economic growth.

Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School, Director of the Harvard Environmental Economics Program, Chairman of the Environment and Natural Resources Faculty Group at the Kennedy School.